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August 20, 2019

So You Got a Cryptocurrency Letter from the IRS, Now What?

Glasses sit on top of tax form.

The IRS is sending letters to taxpayers suspected of failing to report or misreporting cryptocurrency transactions. In the latest round of these letters, the IRS notes that information the IRS obtained from digital currency exchanges does not match data submitted to the IRS by the taxpayer. These letters essentially foretell IRS enforcement of proper reporting for digital currency transactions. So if you get one of these letters, what steps should you take?

Dealing with an IRS Cryptocurrency Letter

The first call should be to a tax professional. Tax professionals can leverage practical experience with a familiarity with your situation to develop an efficient strategy concerning the necessary response to one of these IRS letters. Early communication facilitates a proactive response that is preferable over reactive measures to address penalty assessments. Penalties in this case range from monetary penalties to criminal charges that ultimately could result in a criminal conviction. There are steps that you can take to mitigate the most severe of these consequences, which we will discuss later, but these steps are only effective if taken in advance.

The second step is to understand a bit more about the taxation of cryptocurrency transactions and the information that the IRS is seeking. Cryptocurrencies, such as Bitcoin, are not treated as money for tax purposes; they are instead treated as property which results in a gain or loss when sold or used to purchase other goods or services. Each time a taxpayer buys or sells Bitcoin, for example, a record of the transaction must be maintained in order to calculate the gain or loss. And while all cryptocurrency transactions are recorded in the “blockchain” – and are therefore searchable – it is not unheard of for users to lose their digital “keys,” so a separate record is still advisable.

The Tax Life-cycle of a Typical Cryptocurrency Transaction

When Bitcoin and other cryptocurrencies are used to purchase goods and services, the transaction is treated as an exchange of the cryptocurrency for the good or services. For example, if a taxpayer buys an engagement ring for one Bitcoin, the taxpayer must compare the fair-market value of the ring to the value of the Bitcoin at the time of the transaction. This can be difficult, as the value of Bitcoin remains volatile. If the jeweler then cashes out the Bitcoin for U.S. dollars, the jeweler would also have to calculate a gain or loss on the subsequent exchange. Assuming the jeweler correctly reported income on the sale of the ring, however, his basis in the bitcoin would be equal to its fair market value at the time of the purchase.

In fact, each iterative step involving successive exchanges of cryptocurrency has tax ramifications. Consider a Bitcoin life-cycle that begins with a new Bitcoin mined by a third party. The mining activity results in self-employment or business income (depending on the structure of the miner) that is taxable in the year the coin is mined, and the miner can deduct ordinary and necessary expenses of the mining activity, such as electricity or depreciation of the computer hardware. Then, assume the miner sells the Bitcoin for cash to our happy taxpayer who is set to get engaged. This is another taxable transaction, where the miner recognizes a gain or loss on the exchange of the Bitcoin. Next, assume the taxpayer buys the engagement ring with the Bitcoin. This is another taxable transaction, where the taxpayer recognizes a gain or loss on the exchange. And it is a taxable transaction to the jeweler where the inventory cost of the engagement ring is sold in exchange for the fair value of the Bitcoin. Finally, when the jeweler sells the Bitcoin for cash, the jeweler recognizes a gain or loss on the exchange. So in this “simple” hypothetical, the Bitcoin caused a combined five taxable transactions for the three parties involved. 

Forks and Airdrops

And this does not include other more complicated cryptocurrency transactions such as “forks” and “airdrops.” A fork occurs when a cryptocurrency spits into two different currencies, while an airdrop occurs when free cryptocurrency is deposited into a user’s digital wallet (usually as a promotional method to popularize a new cryptocurrency). Each of these transactions result in users augmenting their current cryptocurrency holding  with new cryptocurrency. To date, the IRS has not issued guidance on these transactions. A fork resembles a dividend in that the user receives additional cryptocurrency proportionate with the current cryptocurrency holding, though it also resembles a stock split when the new coin causes a devaluation of the original cryptocurrency. An airdrop arguably could be valued at $0 initially, and then subject to a capital gains tax when exchanged later. This is particularly attractive and practical for taxpayers, as many of these new cryptocurrencies turn out to be worthless. Given the lack of guidance for forks and airdrops, it is inadvisable to completely omit such items from a tax return. At a minimum, the taxpayer should consider adding a note to his or her return.

Other Considerations for Dealing with an IRS Cryptocurrency Letter

Taxpayers who omitted one or a few small cryptocurrency transactions may find it simplest to amend their returns to include the transactions. But taxpayers with a large number of transactions should discuss disclosure options with their tax professionals. Voluntary disclosure procedures allow taxpayers to mitigate the risk of criminal prosecution for unreported cryptocurrency transactions. Similar disclosure programs were designed previously for taxpayers with unreported foreign assets. In September 2018, the offshore voluntary disclosure program gave way to a more general voluntary disclosure program. The current program is beneficial to taxpayers who receive IRS cryptocurrency letters, as they can qualify for the benefits of voluntary disclosure just as the IRS campaign for cryptocurrency letters commences.

Taxpayers who participate in the voluntary disclosure program are subject to IRS examination, and must pay all penalties, taxes, and interest in full. If a taxpayer fails to cooperate during the examination, or does not pay any of these assessments in full, their eligibility for the voluntary disclosure program may be revoked. This re-introduces a risk of criminal prosecution.

Taxpayers considering the voluntary disclosure program should also note its scope. Generally under a voluntary disclosure program, a taxpayer must provide six years of tax returns and related documents. However, the disclosure period may be shorter or longer depending on the nature and duration of the activity being disclosed. Similarly, the financial penalties may be for as little as one year or expanded to the full six years. These penalties can include civil fraud penalties, accuracy related penalties, and/or failure to file penalties.

As unappealing as each of these options may be, taxpayers must take appropriate action to remedy unreported cryptocurrency transactions. Additionally, the “first-time abatement” penalty relief provisions and the “reasonable cause” penalty relief provisions will likely be unavailable in the near future for recipients of these IRS cryptocurrency letters.

Final Thoughts

The nature of the IRS cryptocurrency letters is to alert taxpayers to the issue and potential consequences of unreported cryptocurrency transactions, so it is hard for recipients to assert reasonable cause for penalty relief, when notice is first provided from the IRS about unreported transactions. In any case, it is critical to develop a response plan when an IRS cryptocurrency letter is received, and a tax professional is an invaluable resource to help formulate this plan. For more information about reporting cryptocurrency transactions and your options if you receive an IRS cryptocurrency letter, please contact us.

2019 Business Tax Planning Supplement

Copyright © 2019, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).

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